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Mortgage-backed securities.

MORTGAGE-BACKED SECURITIES This month's column discusses a consensus reached at a recent meeting of the FASB emerging issues task force (EITF or task force) concerning exchange transactions involving mortgage-backed securities. A FASB staff response on a debt classification question also is presented.

EITF Abstracts, copyrighted by the FASB, is available in softcover and loose-leaf versions and may be obtained by contacting the FASB order department at 401 Merritt 7, PO. Box 5116, Norwalk, Connecticut 06856-5116. Phone: (203) 84 7-0700. ISSUE NO. 90-2

This issue, Exchange of InterestOnly and Pyincipal-Only Securities for a Mortgage-Backed Security, concerns exchange transactions involving mortgage-backed securities.

A mortgage-backed security (MBS) is a participation in a pool of residential mortgages (such as GNMAs and FNMAS). A pool of mortgages with common characteristics (such as 30-year fixed-rate mortgages on single-family residences) is put into a trust and sold to investors.

The cash flows from a mortgage backed security may be stripped and sold to investors separately as interest-only (I/0) securities or as principal-only (P/0) securities. Ownership of an I/O and P/0 security means the investor owns a share of the interest and principal payments, respectively, on the underlying security.

The facts. The task force considered these facts: An investor owns an I/O and P/0 security from different trusts or an investor owns only an 1/0 or a P/0 security. The security is carried on the books at amortized cost.

The investor (1) exchanges either the I/0 or P/O/ with an independent third party, or (2) purchases an I/0 or P/0 security from a third party so the investor now owns an I/0 or P/0 security from the same trust. The investor then may exchange the 1/0 or P/0 securities for the related mortgage-backed security, thus reconstituting the stripped securities.

The investor also might deliver an I/O or P/0 security and cash to a third party who acquires the matching 1/0 and P/0 security and effects the change.

Accounting questions. The accounting questions are:

1. If an 1/0 or P/0 security and cash are exchanged for a mortgage backed security, should the acquired security be recorded at fair value or at amortized cost?

2. If an investor exchanges an I/O or P/0 security from the same trust for the related mortgage-backed security, should the exchange be recorded at fair value or at amortized cost at the exchange date?

The issue. The underlying theoretical issue is whether the exchange involves a culmination of the earnings process. Some believe that in an exchange of an I/0 or a P/0 security for an I/O or P/0 security of a different trust, the acquired security should be accounted for at fair value, unless the exchange involves underlying debt securities that are "substantially the same." They view that exchange as the culmination of the earnings process-the sale of one security and the purchase of a different security.

Others disagree and believe the exchange is only the first step for accomplishing ultimate objective of reconstituting the stripped securities into the underlying debt instruments. Thus, in their view, the exchange does not result in the culmination of the earnings process, and fair value accounting is not appropriate. Until recently, there was no authoritative definition of the term

substantially the same" securities; as a result, diversity in accounting practice developed. In recently issued Statement of Position no. 90-3, Definition of the Term "Substantially the Same"for Holders of Debt Instrument8, as Used in Certain Audit Guides and Statements of Position, the American Institute of CPAs finally provides guidance for determining whether two debt instruments are substantially the same for the purpose of deciding if a transaction results in the culmination of the earnings process. The SOP specifies six criteria to be met for debt instruments to be considered substantially the same.

Consensus. On the first question, the task force decided when an 1/0 or P/0 security and cash are exchanged for a mortgage-backed security, the acquired security should be recorded at fair value.

On the second question, the task force concluded the investor should record an exchange of I/0 or P/0 securities from the same trust for the related mortgage-backed security at fair value at the exchange date.

Some task force members noted I/0 and P/0 securities from the same trust are not substantially the same as the related mortgage-backed security, primarily because the liquidity characteristics and market values are different, and they, therefore, don't meet the criteria specified in the SOP

A FASB example of the application of the consensus is presented in the exhibit on age 79.


Subjective acceleration clauses in debt instruments. The FASB staff reported at a recent task force meeting it responded to a technical inquiry concerning subjective acceleration clauses and debt classification.

Two FASB pronouncements deal with this issue: FASB Statement no. 6, Classification of Short-Term Obligations Expected to be Refinanced, and FASB Technical Bulletin (TB) no. 79-3, Subjective Acceleration Clauses in Long-Term Debt Agreements.

Statement no. 6 permits a short term obligation to be excluded from current liabilities if the company has the ability and intent to refinance the debt on a long-term basis. One way of showing that ability is the existence of a financing agreement that clearly allows the short-term debt to be refinanced on a long-term basis. However, according to the statement, that agreement shouldn't be cancelable by the lender because of a subjective acceleration clause.

TB no. 79-3 says if a long-term debt agreement does contain a subjective acceleration clause and acceleration of the due date is remote, neither reclassification to current liabilities nor disclosure of the acceleration clause is required.

Question. It appears Statement no. 6 and TB no. 79-3 are inconsistent in their treatment of subjective acceleration clauses in debt agreements. Is that the case? FASB staff reply. No. The FASB staff views the circumstances covered by Statement no. 6 and TB no. 79-3 as distinctly different. Under TB no. 79-3, the lender already loaned money on a long-term basis. To continue long-term classification requires assessing the likelihood of acceleration of the due date.

On the other hand, Statement no. 6 covers circumstances in which the obligation by its terms is short term. To exclude that debt from current liabilities, the lender must advance new funds or refinance the short-term debt on a long-term basis based on conditions existing on the date of the new loan or refinancing. Therefore, to classify the debt as long term, Statement no. 6 requires a higher standard for a financing agreement that permits a company to refinance a short-term debt on a long-term basis than TB no. 79-3 requires for an existing long-term loan for which early repayment might be requested. n
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Publication:Journal of Accountancy
Date:Feb 1, 1991
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